Mankiw bullshits us on taxes

Suppose that some editor offered me \$1,000 to write an article. If there were no taxes of any kind, this \$1,000 of income would translate into \$1,000 in extra saving. If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now, when I pass on, my children would inherit about \$10,000. That is simply the miracle of compounding.

Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that \$1,000 of pretax income becomes only \$523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the \$523 in saving grows to \$1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that \$1,700 enters my estate, my kids will get, at most, \$1,000 of it.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra \$10,000. With taxes, it yields only \$1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. [emphasis added]

First of all, why is Mankiw spending about a fourth of his precious column space on this elaborate calculation? The reason is because if he just talked about the actual marginal tax rate on income in excess of \$250,000 per year, he would be whining that instead of taking \$350 out of that \$1,000 — to pay for stuff like roads, police, etc. that Mankiw presumably wants and benefits from — the mean ol' Obama administration would take out a whopping \$396. I mean, gosh! that \$46 bucks (and a buck or two more for higher Medicare costs) is what makes it worthwhile for poor Mr. Mankiw, who teaches at Harvard dontcha know, to get out of bed in the morning. Right? I don't think so. To make his objection plausible, he has to magnify the issue.

Now, there's a case to be made that taxation in general acts as a disincentive. And there's a case to be made that under certain specialized circumstances a system of taxation can have a profound effect on the overall opportunity costs of complicated series of transactions. But to characterize these effects as an effective marginal tax rate is just irresponsible. Macroeconomics 101 (which I'm actually taking now) tells us that money flows in an endless circle, and the government takes its cut (sometimes more than one) on each transaction around that circle. Follow a dollar around the circle long enough and you can make the "effective" tax rate any value you want. Mankiw is talking about at least six separate transactions:

The pay from the editor to him (and the income taxes he pays)

The decision to invest the money instead of consuming it immediately

The sales from consumers to the corporation he invests in

The distribution of dividends and capital gains

The reinvestment of those dividends

The transfer of this wealth to his children

And then he's compounding some of these transactions over 30 years.

I make about \$10,000 per year in income. If I paid one fewer dollar in taxes, I could invest it at 8% for 30 years and, absent any taxes at all, I could pass on \$10 to my kids. Indeed I could say that the tax system — just by taking \$1 from me this year — is "in effect" taxing my great-great-great-great grandchildren a million dollars. What an injustice!

Also... where does this 8% come from? Investment is foregoing consumption in order to grow the economy. The economy (real GDP) grows at between 2% and 4% per year. Where does the expectation of 8% come from? What investment (without precognition or insider trading) consistently and predictably returns 8% per year for 30 years? If there were such an investment, perhaps we should put the Social Security surplus in that instead of Treasury Bills. Not only does Mankiw expect to invest to grow the economy, he wants to take double that growth as a premium.

I want to make it clear: taxation does indeed exert an enormous effect on compound interest over long periods of time. But Mankiw is blatantly bullshitting us with bogus statistics to characterize it as an effective marginal tax rate. The marginal federal income tax rate for income over \$250,000 per year is 35% and may be raised to 39.6%. That's an extra \$46 per \$1,000 earned over \$250,000. Period.

Mankiw then poses a rhetorical question:

Now you might not care if I supply less of my services to the marketplace — although, because you are reading this article, you are one of my customers. But I bet there are some high-income taxpayers whose services you enjoy.

Maybe you are looking forward to a particular actor’s next movie or a particular novelist’s next book. Perhaps you wish that your favorite singer would have a concert near where you live. Or, someday, you may need treatment from a highly trained surgeon, or your child may need braces from the local orthodontist. Like me, these individuals respond to incentives... As they face higher tax rates, their services will be in shorter supply.

Well, yes, but let's turn to page 4 of Mankiw's textbook on economics: the first principle of economics is that people face trade-offs. What are we giving up to have high-income taxpayers provide more services? What's the opportunity cost? Unless I know what I have to give up to squeeze an extra book, concert or New York Times column out of some high-income taxpayer, I don't know if it's actually worth it.

And there's not just one trade-off, but two. First, should we let these high-income taxpayers keep \$46 more per \$1,000 they earn over \$250,000? (Presumably, they have no problem working — and spending — up to \$250,000.) And second, should we allow them to compound this money by saving and investing? And it's the second trade-off that Mankiw is asking us to make.

First, Mankiw implies that saving for his children has lower marginal utility than supporting his family's upper-middle-class lifestyle. If it were not, he would sacrifice part of that lifestyle to increase his savings. So he's asking us to give up something (who knows what?) to support the least of his priorities.

Second, we are — according to many economists — in a global savings glut; we have excess productive capacity. If Mankiw were to tell us that he would buy fewer hamburgers or Armani suits because of the tax increase, there would be a much better case for letting him keep the money. But it is precisely because Mankiw intends to save and invest what we would otherwise tax him that we want to take the money away from him. We don't need savings and investment right now; we have too much savings and investment. We need spending. (Well, we really need a revolution to change the fundamental character of our economic system, but I have my "capitalist" hat on for this post.) So when Mankiw asks to be allowed to keep this money to invest it is akin to asking that he be allowed to keep his gun so he can hunt bald eagles.

Sorry Greg. I wouldn't buy this bullshit for a quarter. Let me call the waaaaaaaaaaahmbulance.

Also... where does this 8% come from? Investment is foregoing consumption in order to grow the economy. The economy (real GDP) grows at between 2% and 4% per year. Where does the expectation of 8% come from? What investment (without precognition or insider trading) consistently and predictably returns 8% per year for 30 years?

I believe he has discovered index funds. According to measuringworth.com the DJIA and S&P500 have averaged about 8.8% over the last thirty years (ten thirty year spans, beginning in 1970 to 1979 and ending in 2000 to 2009) while the NASDAQ pulls 10.65% (only eight runs instead of ten, starting in 1972).

Chris, those numbers look like nominal growth, not real growth. It looks like the real long term growth for stock indexes is GDP plus dividend yield. I'm not sure what that means, but my intuition suggests the "dividend yield" might be a transfer of real aggregate demand from the working class to the investor class. Mankiw would then be arguing that losing an opportunity to screw the working class is part of the "taxation" he faces on his work, which is not a position I can work up a great deal of sympathy for.

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